Tuesday, August 9, 2016

The coming rush of capital inflows - this time will be no different

As investors scramble for yield in a negative rate environment in developed economies, emerging markets (EMs) are becoming the natural attraction. Institutional investors like BlackRock, the world's largest fund manager with $4.6 trillion in assets under management, who are struggling to give back the required 7-8% annual returns for US public pension funds, have become cheerleaders for EMs. The IMF estimates EM growth to increase every year for the next five years, even as developed economies stagnate.

This is a sudden reversal of fortunes for EMs. Consider this,

Until this year, nobody would have taken seriously the idea that emerging markets could make up the shortfall in economic growth. EM stocks spent much of 2015 in free fall, losing more than a third of their value from a peak in April to a trough in January 2016. Economic growth in these countries has been a serial disappointment. As the IMF figures show, aggregate GDP growth in emerging markets has fallen every year since 2010, while the developed world has spent the past three years in post-crisis recovery.

So, what's changed, and that too in such quick time? Nothing fundamentally,

Ruchir Sharma, head of EM equities and chief global strategist at Morgan Stanley Investment Management... says investors in emerging markets are less concerned about whether these economies are growing more quickly than those in the developed world. Rather what excites them is whether the differential between GDP growth in the two is actually increasing. “EM has been growing faster than DM for the past five years and yet EM has underperformed because the differential has been collapsing. This year the differential has stopped collapsing. It has stabilised"...

He dismisses any suggestion that this heralds a return to the glory days of the 2000s, when emerging markets consistently outperformed those in the developed world by a wide margin and foreign capital flooded in. In 2007 — the peak of the boom for emerging markets — there were 60 economies in the world that were growing annually at a pace of more than 7 per cent, Mr Sharma notes. “Today, that number is down to eight or nine countries,” he says... During those boom years, China was the powerful driver of growth, sucking in exports from other emerging markets, especially commodity producers, to sustain a frantic pace of investment and urbanisation. This model has run its course and today... the effort required to make China’s economy “pop” each time is getting bigger and bigger. Before the global financial crisis, says Mr Sharma, China needed one dollar of credit to deliver one dollar of growth. Now the ratio is six to one. "They are finding it impossible to grow without increasing quantities of debt,” he says. “It is the kiss of debt.

This is a critical inflection point for EMs. In the months ahead, capital inflows into EMs as an investment destination will increase. The better performing ones like India are likely to get more inflows. Foreign capital borrowings will appear very cheap for their non-financial corporates. The stability of rupee is also likely to encourage these borrowers to go unhedged. As the tide rises, the domestic cheerleaders of foreign capital inflows are likely to up the ante, demanding further deregulation by removing withholding tax etc. Will the new Central Bank Governor resist the temptation and run the risk of being accused of hindering growth by depriving the country of ultra-cheap foreign capital?

For an economy of its size, India has disproportionately lower exposure to global financial markets. That may be about to change. And for sure, it will bring benefits in its wake in the form of access to cheaper capital. But, the costs can be prohibitive. The risks are especially so given the small size and limited depth and breadth of the country's financial intermediation, the fragility of its regulatory institutions, the very poor general corporate governance standards, and a deeply populist political economy. And, the first exposure to such critical transitions will generally always leave excesses in its wake.

It requires rare courage to cut through the illusions of being the "next big thing" and understand the dynamics of such capital inflows. As I've blogged earlier, such capital flows are dictated by the attraction or otherwise of EMs as a collective asset class. Among them, capital would show a greater preference for those which are more attractive at that point in time. So, given its current economic prospects, India is likely to be a beneficiary. But very little of these flows are motivated by long-term bets. Once the tide turns, as it must, sudden stops and flows reversals follow. Nothing, including sound macroeconomic fundamentals, can cushion against such reversals. Those swimming naked, with unhedged bets and excessive exposures, as there will be many corporates including from India, will get shown up. But by then, it would have been too late.

As recent IMF research has shown, capital controls are far more effective in managing inflows than outflows. There is little that can be done to limit the vulnerabilities from EM capital flow reversals after gorging massive volumes of foreign capital. Therefore, the central bank should exercise the greatest caution before any relaxation of restrictions on capital inflows, influenced by the availability of cheap global capital.